Prof. Howard Davies Presentation

7/30/2019 Prof. Howard Davies Presentation

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Lessons of the financial

crisis: what have welearned?

Howard Davies

Professor Sciences Po

Vilnius3 May 2013


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Source: IMF Working Paper WP10/213Adjustment under a Currency Peg: Estonia, Latvia and Lithuania during the Global Financial Crisis 2008-09


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1. What went wrong?

2. Where have we reached broadconsensus on a response?

3. Which major issues remain unresolved?


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Source: The Economist, March 20, 2012 - http://www.economist.com/blogs/graphicdetail/2012/03/focus-2

The crisis delivered a sharprecession, and now a double-dip

in some placesGDP Growth 2007-11


7/54Source: International Labour Organization - Global Employment Trends 2012

With a large increase inunemployment

Global unemployment trends: 2000-2011


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As severe as in any post-warrecession


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Source: This Time its Different, Rogoff, K. and Reinhardt, C.M., 2009

Cycles of past unemployment and banking crises

Recessions which begin in the financialsector are severe and long-lasting


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The crisis boosted governmentdebt in developed countries

Source: MGI Jan 2012Debt and deleveraging: Uneven progress on the path to growth


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- Global imbalances- Growing inequality leading to consumer

borrowing- Loose monetary policy, leading to

mispricing of risk credit bubble

- Excess leverage, facilitated by procyclicalregulation, and regulatory arbitrage

- Excess unmanaged growth of the financialsector, which magnified risks, rather thandiversifying them

What are the underlying causes?


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Global current account imbalancesgrew rapidly from 2003

Estimates of account balances for selected countries ($ Billion), 1993-2009

Source: http://www.fsa.gov.uk/pubs/other/at_29oct09.pdf Datastream, FSA Calculations.


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European banking assets grewrapidly

Assets of European listed banks, 1987-2009

0

5

10

15

20

1987

1990

1993

1996

1999

2002

2005

2008

Totalassets(EU

Rt

r)

Danske Bank A/S

Nordea Bank AB

Banco Bilbao VizcayaArgentaria, S.A.

Dexia SAIntesa Sanpaolo SpA

Commerzbank AGUniCredit S.p.A.

Societe Generale Group

Banco Santander, S.A.

Lloyds Banking Group plc

Deutsche Bank AG

Barclays plc

Credit Agricole SAHSBC Holdings plc

Royal Bank of Scotland GroupplcBNP Paribas

1988

1991

1994

1997

2000

2003

2006

2009

1989

1992

1995

1998

2001

2004

2007

Source: Capital IQNote: Chart shows total assets over time for top 16 listed European banks. The bank ranking used wa


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Derivative volumes exploded

Source: Datastream, BIS/ Financial Stability Report October 2008 by Bank of England

Outstanding Notional amounts of Derivatives

WorldGDPUS $

trillions


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Household debt as % of GDP, 1987-2007

Source: FSA, ONS, Federal Reserve, Eurodata, Datastream

Household debt rose sharply


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Act One: Subprime

Act Two: Liquidity

Act Three: Unravelling

Act Four: Meltdown

Act Five: Pumping

The Credit Crisis: A Five-ActShakespearian Tragedy


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Whom do the British blame for thefinancial crisis?

28

24

10

2

3

11

9

12

1

Bank executives

Governments

Financial regulators

The media

Central Banks

Thatcher and Reagan 1980s deregulatory

reformsConsumers for borrowing too much

Everyone (democratic society for its collective

failure to policy the above)

Other

%

Source: Thisismoney.co.uk, June 2009

Question: Who is most to blame for the current financial crisis?


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Macro imbalances, loose monetary policy andfinancial innovation

Rapid credit growth, asset price bubbles,overborrowing

Badly managed and unscrupulous financial firms

Flawed assumptions about market efficiency andinvestor rationality

Global finance without global government

Such a complex failurehas many parents


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What has changed?

- The global regulatory system has beenoverhauled


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The system was widely perceived tohave failed in the run-up to the crisis...

Structural problems revealed by the crisis

- Warnings of trouble ahead were ignored

- Needed reforms took years to agree, leaving acknowledgedvulnerabilities uncorrected

- The system was over-complex and there was no discipline orauthority among the different bodies

- The membership was unrepresentative and out of date

- The US was excessively dominant, and the EU spoke with many

voices- The system left too much scope for regulatory competition and

arbitrage


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G7 G20

Source: BBC


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G20

- Formed in 1999 as a group of finance ministersand central bank governors. Top 19 countriesby GDP, plus EU, IMF and World Bank. Spain

and Netherlands also invited- Became Heads of Government meetings in

2008 and replaced G8 as main economicdecision-making body

- Six-monthly meetings

- Rotating chair, no permanent secretariat.


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What has changed?


- The Basel Committee has increased thecapital banks must hold, to make themsafer


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In, but not of, the Bank for InternationalSettlements, the BCBS is the mostimportant global standard-setter

- Formerly G10, now G20

- Central Banks and Supervisors (whereseparate)

- Sub-groups on capital, liquidity, etc

- Capital Accords legislated in EU,implemented on best endeavoursbanks elsewhere

- Apply in theory to large cross-borderbanks (but now in practice to all banks)

Committee of Governorsand Heads of Supervision

Basel Committee ofBanking Supervision

The Tower of B asel


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There have been three BaselCapital Accords

Basel II Basel IIIBasel I

1988 1996-2006 2010-2011

-Cooke ratio-8% minimum-Simple, but not

very risk-sensitive

-10-year gestation-3 pillars-Overall system capitalassumed to remainconstant-Several versions,highly complex-Heavy reliance oninternal models

-Higher capital-Varies throughthe cycle

-Additional capitalfor systemic firms-Tough rules onthe quality ofcapital


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What has changed?


- The Basel Committee has increased thecapital banks must hold, to make themsafer

- Regulation has been overhauled in manycountries


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- Financial firms would have an incentive not tobehave imprudently, to ensure their ownsurvival and profitability

- The private sector control mechanisms wererobust

- Intrusive and rigorous regulation would be

damaging, and costly in terms of foregonegrowth

The regulatory system wasconstructed on the assumption that:


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The Dodd-Frank Act is presented asa major reform of US regulation

Dodd-Frank Act

- 2300 pages of legislation

- Structural changes to US regulatory system

- Enhanced powers (and financing) for manyregulators

- Reforms of the Federal Reserve


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The Changing Lexicon ofRegulation


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Unresolved issues

1. Too Big To Fail


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State aid measures in the context ofthe financial and economic crisis

Source: Likanen report October 2012


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Moral hazard is at the root of the'too big to fail' problem

Moral hazard

- Any situation in which one person makes thedecision about how much risk to take, whilesomeone else bears the cost if things go badly(Paul Krugman)

- In banking, riskier loans, and higher leverage canbe expected in good times to raise profits andtherefore remuneration for managers. In bad timestaxpayers will bail out the banks to avoid theadverse economic and social consequences ofbank failures. That is especially true of retailcustomers, whose deposits are largely guaranteed.

Past efforts to offset moral hazard


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Past efforts to offset moral hazardhave not been very successfulToo big to fail: possible remedies

Capital requirements/leverage ratios:

- Did not work efficiently pre-crisis

- Can encourage riskier lending to maximise return from givenleverage.

Supervision of risk-taking:

- Not very effective in the past

- Supervisors do not know enough, and perhaps cannot

Constructive ambiguity:

- Central banks may saythey will not intervene, but may be forcedto do so in the event.

Control of incentives/compensation:

- Is it possible to control incentives closely without becomingshadow directors?


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So more radical ideas have beenadvocated (1/2)

Moral hazard: new proposals

- Volcker rule to restrict proprietary trading

But:

affects only a small part of investment banks' portfolios

- 'Ring-fence' retail activities and restrict lender of last resortsupport to retail activities

But:

Is it credible to deny any possibility of support to commerciallenders?

Does it create safer retail banks, or reduce diversificationeffects?


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So more radical ideas have beenadvocated (2/2)

Moral hazard: new proposals

- Enforce separation of retail/small business lending

But:

May be costly for the system on the whole and create lessdiversified banks which are riskier

- Limit public support to 'narrow banks' undertaking a range ofsafe-keeping activities

But:

Increases the risk of the rest of the system

May raise credit costs for all other borrowers


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Unresolved issues

1. Too Big To Fail

2. Ethics and rewards in banking


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How much was Lloyd Blankfein(Chairman of Goldman Sachs)

paid in 2007?

$0

$22 million$45 million

$54 million

$73 million


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Historical Excess Wage in the Financial Sector

Source: NBER Working papersWages and human capital in the US financial industry, January 2009

Relative pay was at an all-time high in 2010

Only Premier League football clubs paid out as


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(Pay as a % of revenues)

Source: The Economist, special report on International banking, May 2011

Only Premier League football clubs paid out asmuch to their staff


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But job security may not be high


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- Incentive payments can drive risk-seekingbehaviour which causes institutional failure,financial instability and imposes costs ontaxpayers

- It may be a symptom of other competitive orregulatory problems

- Growing income inequality may contribute tosocial resentment and instability

Why should we care about high pay?


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There are five lines of attack:

1. Transparency: name and shame

2. Regulatory controls on incentivestructures

3. Empowering shareholders to controlmanagement

4. Higher marginal tax rates or pay-relatedlevies

5. Direct limits on remuneration

How effective have these


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- Annual payments to top Wall Street tradershave fallen, but remain in 8 figures

- Senior Executives have taken significant pay

cuts (though largely because profitability hasfallen)

- Some activities are moving out of traditional

centres, and/or regulated firms, to avoiddisclosure and pay constraints

- Overall, financial sector rewards remain

remarkably high

How effective have thesemeasures been?


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Unresolved issues

1. Too Big To Fail

2. Ethics and rewards in banking

3. The EMU dilemma


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Bruegel 2012/01 The Euro crisis and the impossible trinity


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So far, EU leaders have:

- Rejected mutually guaranteed borrowing- Rejected a fiscal union

- Resolved to create a banking union, but

- Without a centrally funded resolutionauthority, or

- A mutually guaranteed deposit protection

scheme

This looks to be an inadequate response


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Lessons of the financialcrisis: what have we

learned?

Howard Davies

Professor Sciences Po

Vilnius3 May 2013

Prof. Howard Davies Presentation

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